PROCESS
OF RECOVERING FROM A CATASTROPIC LOSS
INCOME
AND PROPERTY TAXES CONSEQUENSES AND REQUIREMENTS
PART
1
For Individuals and Businesses and
Investors in Tangible Property:
1 TOOLS
FOR RECOVERY
2 INCOME
TAX LAWS AFFECT PEOPLE WHO EXPERIENCE A LOSS
3 INSURANCE
vs. OTHER SUPPORT
4 COST
BASIS OF PROPERTY DAMAGED
5 DOCUMENTING
– A GAIN OR A LOSS?
6 TAX
REPORTING FOLLOWS THE INSURANCE PROCEEDS
For Individuals and Businesses and
Investors in Tangible Property:
This
material is divided into sections that cover specific areas of the tax
consequences related to the recovery process from a catastrophic physical
property loss. The following is an overview of the concepts that are covered:
The
material primarily addresses the losses of individuals for personal, business
and investment losses. Where differences arise for businesses not operated in a
sole proprietorship, such as partnerships, corporations and LLCs the
differences will be separately stated.
Circumstances
(Disaster or other Catastrophe)
Type of loss:
complete loss or partial loss
Assets lost
Loss or Gain
Computing the loss or
gain
Qualified Replacement
property
Tracking the recovery
/ Reporting
Compliance issues
Changes:
Circumstances
“Change of mind”
Complications,
Interpretations, Clarifications
Other:
Interest and Property
taxes
1 TOOLS
FOR RECOVERY
For
every job, tools are required. Recovering after a catastrophic event is no
different. Whether recovery is assisted by insurance proceeds, income tax
benefits or a combination, documentation is required to substantiate both
insurance and tax aspects. Anything you do to improve the quality of the
documentation will increase your recovery success.
Always keep a diary of all
conversations, document the physical aspects of the recovery by photographing
everything you can. Photographic documentation is always evaluated in
hindsight. We look back and say, “if only I had recorded the status of that
damage three months ago.” To avoid this lament, record as often and, in as much
detail as you can. Later, you can decide what is no longer useful rather than
being sorrowful about what was not recorded.
People who
have experienced a major physical catastrophe can be expected to be “angry,
confused and vulnerable.” There are normal responses to being subjected to
“tremendous stress.” In the usual case homes have been destroyed, these homes have
been the prime physical source of family stability and safety. These people are
likely in “psychological
shock.” In a natural response, taxpayers
doing their best will find new creative ways to deal with the complexity of the situation.
For an official list of federally declared disasters go to Www.FEMA.gov/disasters.
2 INCOME
TAX LAWS AFFECT PEOPLE WHO EXPERIENCE A LOSS
It
is imperative to understand that the tax laws related to casualties and
disasters are unusual. For one, we have to understand that the basic law
involves a claim of taxation of all receipts and non-deductibility of personal
losses. Therefore, the two code sections 165 and 1033 and others are unique in
that they reduce or eliminate taxation of insurance proceeds and allow deduction
for personal losses. It turns out that sometimes even the tax laws can display
empathy for the people who have been affected by such things as casualties and
disasters.
The
tax law differentiates between realization of income or a loss and recognition
of the item as a tax return reportable event. Realization refers to the receipt
of cash or having experienced a loss (the event). Recognition involves
reporting the event on a tax return. Some events are reportable and others are
not. Some have several circumstances that must be understood to determine if
the realized event has any effects that must be reported to the Internal
Revenue Service and state tax authority on a tax return. The material in this
document discusses the major aspects of realization and recognition for the
bulk of aspects related to a casualty or disaster event.
3 INSURANCE
vs. OTHER SUPPORT
In addition to insurance proceeds,
additional funds may become available to taxpayers as a result of a
catastrophic event. For individuals, many of these payments are free of any tax
consequences. They can come from FEMA, the state, local governments, non-profit
organizations and even employers. Generally, payments given without any
“strings” or to reimburse medical, housing, or burial expenses are not subject
to tax. Payments requiring the payments be used to repair the home or
reimbursement for damages to the home must be treated as additional insurance
proceeds. But if they are paid to the taxpayer without any restrictions other
than they are assistance in regards to the taxpayer having experienced a
specific catastrophic physical event, then they are “tax free.”
SMALL
BUSINESS ADMINISTRATION LOANS
Securing a Small Business
Administration (SBA) loan as part the recovery does not create taxable income.
It is a contract that includes an obligation to re-pay money borrowed plus
interest. In some cases, the SBA will forgive a portion of the loan once it is
reduced to a specified balance. The forgiveness does have income tax
consequences. A forgiveness of indebtedness is treated in the same manner as
additional insurance proceeds. The treatment of the forgiveness depends on
several factors including:
· The time period in
which the forgiveness occurs,
· The replacements made
by the taxpayer,
The forgiveness may
be taxable or simply reduce the Adjusted Cost Basis of the replacement
property.
SBA
DISASTER DECLARATIONS
The SBA may make disaster declarations
without a “Federal Disaster Declaration” being made. The SBA declarations only
make their disaster relief loans available to taxpayers; it does not make the
event a Federal Disaster that allows taxpayers to take advantage of special disaster
tax benefits. Federal disaster declarations are listed at FENA.gov /
disasters.
4 COST
BASIS OF PROPERTY DAMAGED
Cost basis is only an important
component in the recovery process for income tax considerations. For insurance,
it is only important that the insured prove the cost to replace the damage,
that is not the same cost basis that we are concerned with for tax purposes.
Cost can be simple. For a home that was not modified after acquisition, the
purchase price plus some of the closing costs would be its cost basis. That
rarely is the case. Maintenance expenditures are not part of the cost basis.
The cost of mowing the lawn is not an improvement, the cost of planting a tree
or a rose bush is an improvement.
Items acquired by gift or inherited
have special rules. The “cost” of an item received as a gift is determined
differently from items that are received through inheritance.
In prior years, before the recent
housing value downturn, we would not be too concerned with the next step as the
assumption had been that real estate values are increasing. In fact, for
determining a gain, that is where the computation of cost basis does stop. For
purposes of determining a loss, an additional consideration comes into the
computation: The fair market value of the property immediately before the
catastrophic event. If that fair market value is above the actual cost basis,
there is no adjustment to the cost basis. If the fair market value is less than
the actual cost, the cost is “adjusted” to the fair market value to arrive at
the “adjusted cost basis.” The decrease in fair market value that results from
the difference between the fair market value and the actual cost is considered
a personal, non-deductible loss. When the IRS examines a return, they look for
personal losses inappropriately deducted in the return.
The following example demonstrates how
fair market value below the actual cost affects the computation of a loss.
The cost of real estate involves
categories such as land, building, landscaping, asphalt driveways, patios, etc.
For personal use real estate, the cost of each category is not relevant. If the
building burns, the loss is not limited to the cost of the building. For
personal real estate, the IRS looks at the cost of the complete property as one
“integral unit.” Even though the land does not burn, the loss is computed on
the reduction in the value of the whole property. The loss is compared to the
adjusted cost of the whole property, including land. Cost is the attributable
to the property is the maximum limit of the loss.
Cost
|
$
|
2,000,000
|
Value
before event
|
1,700,000
|
|
Value
after event
|
1,000,000
|
|
Loss in
value resulting from loss
|
700,000
|
|
Insurance
Proceeds
|
500,000
|
|
Adjusted
Loss before deduction limitations
|
$
|
200,000
|
The decrease in value
before the casualty of $300,000 ($2,000,000 purchase less $1,700,000 value
before the event), is not part of the deductible loss, but it still remains
part of the cost basis for the asset going forward.
The example below does not
include insurance proceeds. The decrease in value is $500,000 (value before the
event, $900,000 less the value immediately after, $400,000). The loss is
limited to the cost basis ($400,000), which is less than the loss in fair
market value ($500,000).
Cost
|
$
|
2,000,000
|
Value
before event
|
1,700,000
|
|
Value
after event
|
1,000,000
|
|
Loss in
value resulting from loss
|
700,000
|
|
Insurance
Proceeds
|
500,000
|
|
Adjusted
Loss before deduction limitations
|
$
|
200,000
|
The above example also demonstrates a
concept in the tax code, “integral nature.” The “integral nature” concept make
a distinction between personal use real estate and other real estate. For
personal use real estate, there is no need to allocate between land and
improvements when determining the loss from a casualty. In other words, based
on the above example, although the construction costs were $300,000, the
allowed loss was based on the total cost of $400,000. Therefore, while cost is
a limit, of the economic loss of $500,000, the taxpayer is allowed to deduct
the full cost of $400,000.
The following example demonstrates a
gain: The total cost, including the land is $400,000. That is compared to the
insurance proceeds of $1,000,000. An exclusion that is discussed later,
$500,000 reduces the gain of $600,000 to a $100,000 gain realized. The realized
gain may be deferred or reported as a capital gain.
Land
|
$
|
100,000
|
Cost
of construction
|
300,000
|
|
Total
Cost
|
400,000
|
|
Insurance
proceeds
|
1,000,000
|
|
Gain
before exclusion
|
600,000
|
|
Sec
121 Exclusion
|
500,000
|
|
Gain to Defer
|
$
|
100,000
|
The last example combines two elements of the above examples.
Land
|
100,000
|
||
Cost
of construction
|
300,000
|
||
Total
Cost
|
400,000
|
||
Value
before
|
900,000
|
||
Value
after
|
400,000
|
||
Decrease
in value
|
500,000
|
||
Insurance
Recovery
|
150,000
|
||
Adjusted
Loss before limitations – limited to Basis less Insurance proceeds
|
$
|
250,000
|
There are cases where the allocation of cost between land and improvements will be required because both business and personal use are involved.
Gifts have a cost basis
that is called “carryover basis.” It is generally the cost basis in the hands
of the person making the gift, but it cannot exceed its fair market value at
the time of the gift.
Inherited
items
have a cost basis that is equal to the fair market value, generally, at the
date of death of the person who made the bequest.
Assume that Aunt Jenny gives an antique
that she purchased 60 years ago for $10.00 that has a value at the time of
making the gift of $100.00. The person who receives the gift has a cost basis
in the antique of $10.00. On the other hand if Aunt Jenny gifts her car that
she paid $15,000 20 years ago that now has a value of $1,000, the person
receiving the car has a cost basis of $1,000 for that car. If these items had
been received as bequests after the death of Aunt Jenny, these items would have
a cost basis to the person receiving them of $100.00 for the antique and $1,000
for the car.
5 DOCUMENTING
– A GAIN OR A LOSS?
The IRS does not specify how records should be kept. They do require
that the records be kept in a manner that allows the taxpayer to demonstrate to
them that the reporting on a tax return results in the “correct tax.”
Generally, taxpayers do not have to submit documentation with the return when
it is filed. The substantiation must be maintained by the taxpayer.
The
need for adequate documentation cannot be over-stressed. However, courts have
been reasonable where the critical documentation has been destroyed in the
casualty event. This does not mean that taxpayers should be loose with their
documentation record keeping. In fact, while the courts may show leniency a
taxpayer with full documentation will do better than a taxpayer relying on the
kindness of a judge.
In addition to the formal records of
the home’s purchase and major improvements, other materials are often useful to
demonstrate cost. It is unlikely that a taxpayer has all the receipts for all
the linens in a closet. A photograph of the closet might add some level of
proof in addition to the photograph being a memory aid to list all the items
stored in the closet. The loss on personal property is limited to the lower of
the value of the items just before the event or their cost. The receipt for a
custom-made couch is wonderful, but a recent photo will show its condition
demonstrating a level of “depreciation” in value due to use.
A list of major items that are
important evidence in the documentation process include the following:
Basic acquisition cost, improvements
Adjustments – decrease in value before
event
Inherited property
Valuations (before / after)
Appraisal (& Appraiser)
Cost of Repairs methods
Physical location of items lost
Insurance proceeds
Replacements (Repairs and /or
Acquisitions)
6 TAX
REPORTING FOLLOWS THE INSURANCE PROCEEDS
The payment of insurance proceeds
should be documented very carefully, including a photocopy of the check. Retain
any materials that the insurance company sends with the payment or as support
for the payment. Often, the insurance company will have codes on the check or
stub. If the material accompanying the check does not include an explanation of
the codes, ask the company for the key to the codes. Verify the codes related
to the payment are consistent with your understanding of what was being
compensated for in the claim. Note on claim documents when the when the claim
was filed, how much was claimed compared to the amount paid, and reasons for
differences.
The insurance policy can provide
payments for the following:
Real property – Structure (usually
Coverage “A”)
Real property – “Other Structures”
(usually Coverage “B”) generally 10% of Coverage “A.” Additional coverage can
often be acquired.
Personal property (Contents) (usually
Coverage “C”), generally 50% to 75% of Coverage “A.” Additional coverage can
often be acquired.
Additional Living Expenses (usually
Coverage “D”), usually based on the quality or living standard as determined by
Coverage “A.”
Other coverage for “Scheduled Property”
items, (specifically listed in the policy).
Medical expenses
Flood insurance is only available
through a federal program.
Earthquake coverage is most often a
separate policy. Coverage quality can vary over a wide range.
Some insurance proceeds may be income,
or be tax-free. They may be subject to partial tax-exclusion and the balance
subject to possible tax-deferral.
All evidence related to spending funds
to return to a pre-event status, including acquisition of replacement property
and the cost of repairs and experts must be retained as evidence of the
reinvestment. Using a computer worksheet to summarize the accounting for the
funds in addition to maintaining the actual source paperwork is essential. The
specific tax treatment of each type of insurance payment is covered in this
material.
Vehicles, boats, trailers, etc., all
have separate insurance coverage availability and thus are treated separately
when reporting a loss for tax purposes.
Business losses are treated separately
from personal losses, even when the business is operated from the personal
residence.
Reporting a gain or a loss will be
based on the taxpayer’s receipt of funds in each of the specific categories
compared to cost basis or adjusted cost basis of the assets lost or damaged.
“Tax
Elections,” Decisions and Tax Consequences
POSSIBLE OUTCOMES: 7 NO GAIN OR LOSS
8 A
LOSS
9 A
GAIN
|
FIRST STEP SECOND
STEP
Cost Basis Determine
Preliminary FMV
Insurance proceeds
Analysis is completed by category
Allocation between damaged and
undamaged property
(Total cost for personal use real
estate is available to absorb tax loss)
Area? / Relative value? / Something
else?
“Tax elections,” Decisions and Tax
Consequences
When
an event occurs, the first thing that you need to do for tax purposes is
determine if there is a gain or a loss. Your initial analysis may later change,
but the initial analysis will assist you the early days of the recovery.
However, it is important to keep the possibility of an alternative conclusion
in mind.
It
is also important to refrain from rushing into a loss claim on a tax return. While
the initial benefit may be very enticing, a later recovery that requires a
reversal of the original loss can be very costly. The initial benefit may get
you $15,000 in tax savings, but the later recovery could easily cost you
$25,000 or more.
It
is possible to have a gain in one category while having a loss in another
category.
The
IRS has a number of useful booklets for taxpayers who experience a
catastrophic physical event. The IRS has combined a number of these separate
publications in two publications,
2194 for
individuals and 2194b for
businesses.
The
booklets can be accessed on the IRS website at www.irs.gov.
|
All rights to reproduce or quote
any part of the chapter in any other publication are reserved by the author.
Republication rights limited by the publisher of the book in which this chapter
appears also apply.
JOHN
TRAPANI
|
||
Certified
Public Accountant
|
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2975
E. Hillcrest Drive #403
|
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Thousand
Oaks, CA 91362
|
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(805)
497-4411 E-mail John@TrapaniCPA.com
|
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Website: www.TrapaniCPA.com
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Blog:
www.AccountantForDisasteRrecovery.com
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It All Adds Up For You
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This material was contributed by John
Trapani. A Certified Public Accountant who has assisted taxpayers since 1976,
in analyzing and reporting transactions of the type covered in this material.
Internal Revenue Service Circular 230 Disclosure
This
is a general discussion of tax law. The application of the law to specific
facts may involve aspects that are not identical to the situations presented in
this material. Relying on this material does not qualify as tax advice for
purpose of mounting a defense of a tax position with the taxing authorities
The
analysis of the tax consequences of any event is based on tax laws in effect at
the time of the event.
This
material was completed on the date of the posting
© 2011, 2012 & 2013 John Trapani, CPA,
